x Abu Dhabi, UAEThursday 18 January 2018

Shopping baskets laden with speculation

Market reaction to rising food price rises cannot be hasty or ill-considered if inflation is to be kept under control. Now that the US Fed has acted caution is paramount.

Food prices are in an upward trend across the region, except for in Bahrain.
Food prices are in an upward trend across the region, except for in Bahrain.

Inflation data released in the UAE last week showed that some limited price pressures are beginning to take hold. Headline inflation hit 1.2 per cent year-on-year in September, up from 0.9 per cent in August.

This is hardly a stunning rise but it is consistent with price pressures developing elsewhere in the emerging world. In the GCC the pattern is becoming well established, with food price inflation a particular culprit responsible for a significant portion of price gains.

As with some other major markets, there is a substantial gap opening up between core (excluding food and energy) and headline inflation rates. Whereas headline inflation rates range between minus 1 per cent (Qatar) and 6 per cent (Saudi Arabia), food prices are increasing by 11 per cent year on year in Kuwait and 8 per cent in Saudi Arabia, 6 per cent in Bahrain, 4 per cent in Oman and 1 per cent in Qatar.

In the UAE they rose by an annualised 7 per cent in September, up from 4 per cent in August. In all cases other than Bahrain, the trend in food inflation is up.

The rise in food prices is part of a wider issue. In most cases, food inflation has moved up decisively since the US dollar began to slide in May as commodity prices are mostly quoted in dollars. It also coincided with renewed strength in Asian economies as demand for commodities resumed.

Last week India and Australia raised interest rates in recognition of such growth and inflationary risks. It appears the rise in food prices is part of a broader theme of generalised commodity market and global asset market strength.

These have been driven by two factors. Anticipation of further quantitative easing (QE) by the US Federal Reserve last week became a reality with a further US$600 billion (Dh2.2 trillion) of US Treasury bond purchases, providing an improved appetite for risk assets. The weakening dollar is also a function of the Fed's expansionary monetary policy.

Ironically the Fed's strategy, designed to bring about a rise in inflation in the US, is achieving this almost everywhere but in the US, where inflation is falling. Zero interest rate Fed monetary policy combined with QE (keeping bond yields at historically low levels) is feeding capital flows into emerging markets and promoting growth there, rather than stimulating demand in the US.

Consumer prices in the US are running at 1.1 per cent year on year on a headline basis and 0.8 per cent in core terms (the lowest levels since 1965). Without impetus, they appear poised to sink back into deflationary territory.

The injection of fresh monetary stimulus directly into the US economy is unlikely to change matters much, as consumers and businesses sit on their hands in the knowledge that low interest rates are likely to be here for some time to come. At the same time, banks and financial institutions prefer to channel their cheap capital into higher yielding and appreciating assets in Asia and elsewhere.

US monetary policy has effectively gone global, sponsoring growth and inflation overseas, rather than benefiting the local economy at home. While one result of this should be to gradually reduce global trade imbalances, as US imports fall and those in Asia rise, in the shorter term these imbalances are worsening.

Asian trade surpluses are rising, in part because imports priced in dollars are becoming cheaper. There is also the significant risk that other imbalances will emerge through the creation of asset market bubbles. Divergent economic conditions also mean that global policy co-ordination will remain extremely challenging, lending itself to potentially dangerous outcomes including the possibility of trade wars.

We could also see bubbles in commodity markets. Contrary to expectations that commodity prices might be entering a "super cycle" in which strong demand from emerging economies drives a multi-year bull market, the more likely outcome may be less straightforward, especially should such bubbles start to burst.

Evidence of end-user demand for many commodities that have been rising in dollar price terms remains mixed. In other currencies, many commodities have hardly changed in value, and indexes that track global freight, such as the Baltic Dry index, have actually remained quite weak. But overall global trade is on the rise (witness the recent profits of DP World) and metals demand has been strong, boosted in China's case by inventory building.

Once this runs out of steam, however, downside risks could return. Responses to food price-driven inflation should be carefully calibrated should price rises they are intended to head off prove transitory, especially if the end result eventually turns out to be a bigger collapse.

About a year ago Wen Jiabao, the Chinese premier, is reported to have said: "I've seen the stock market go from 2,000 to 6,000 and back to 2,000 and now back up to 3,000 … I know how to deal with that … what I need to know about is food inflation".

Administrative measures have since been adopted by China to address asset market gains (particularly in property), but nothing to directly dampen food prices.

In this region higher prices usually elicit a variety of responses. In 2007-08 the combination of a falling dollar and rising demand for commodities by emerging market nations, in a more aggressive manner than today, led to a sharp increase in food prices. The surge in inflation was countered with wage subsidies and other non-market measures that served only to make price pressures worse by validating increased inflationary expectations and rewarding price rises by distributors.

It is important that authorities in the Gulf do not attempt to counter food inflation with subsidies this time around. Food prices also cannot be countered by interest rates, particularly in economies with fixed dollar-linked exchange rate regimes.

Revaluation of local currencies might appear to be an attractive option, but in reality this would be no panacea either. Dollar weakness may also turn out to be temporary, and if the economic recovery proves to be shallow the danger is that revaluation could make matters worse.

This leaves fiscal and competition policy, increasing competition and the removal of monopolistic practices among distributors. Policymaking should be focused on this area if price pressures continue to build, since it is only through strutcural reforms that productivity gains can become truly embedded.

These will stand regional economies in good stead regardless of how the external environment evolves.


Tim Fox is the chief economist at Emirates NBD and is writing here in a personal capacity